One of the most incredible shows the world has ever seen was at the American Museum in New York in 1856. This museum contained a vast array of curiosities and freaks, but the most amazing highlight was the 6-Foot-Tall Man Eating Chicken.
Such a creature sounds impossible and horrific, but it was one of the key attractions of the museum. People would stand in line for a brief glimpse of such a beast. And who can blame them? After paying a few pennies for admission, they'd be ushered into a room, the curtains would be pulled back, and the stunning attraction would appear before them, just as described ...
A tall man, seated at a table, gnawing on some chicken wings.
The greatest show on earth
Whatever else you say about P.T. Barnum, the mind behind the Man Eating Chicken, the fellow knew how to woo a crowd. While people didn't always get exactly what they expected, they'd certainly be entertained. It reminds me of how some people approach investing.
These people dream about making a quick buck on the stock market. But rather than focus on the strategies that work, they'll look for a great story told by press releases that could have been written by P.T. Barnum's grandson.
I'm thinking here about companies like Commerce One. Back in mid-1999, the hype around Internet companies was reaching its peak. Business-to-consumer companies such as Amazon.com (Nasdaq: AMZN ) and Dell (Nasdaq: DELL ) and consumer-to-consumer companies such as eBay (Nasdaq: EBAY ) had already proved that the Internet could increase efficiencies and change markets. Early investors in these companies made immense amounts of money as these companies exploited the new sales channel to transform retailing.
About that time, Commerce One launched its IPO, and it soared. If B2C and C2C companies were so great, the reasoning went, business-to-business companies must be even better. Investors were rewarded, as B2B companies were among the top gainers of 1999. The world was changing, and the sky was the limit. That is, unless you happened to recognize that the business results weren't following the hype.
Turns out that B2B was harder than everyone thought, and the business models simply didn't work. Commerce One went bankrupt. Investors were left with nothing but an entertaining story.
Of course, most investors aren't just in it for entertainment; they actually want to make a profit. If you're such an investor, you should avoid overhyped companies, since the returns rarely measure up. Fortunately, many of these companies share similar traits that serve as warning flags for investors:
- The company has a me-too product. If the company is suddenly touting its entry into a hot new niche or business, you should be cautious. If the new product is only obliquely related to the existing business, you should be scared.
- The company shows poor results. If the company is struggling to grow its revenue or make a profit, you should be suspicious. All great companies started from nothing, but if the business seems more focused on producing press releases than sales, there's something wrong.
- The company doesn't have credibility. If the business is planning to start from nothing and transform the world, be skeptical. When Apple Computer (Nasdaq: AAPL ) says it's going use iTV to displace the Cisco Systems (Nasdaq: CSCO ) and Motorola (NYSE: MOT ) duopoly in set-top boxes, I can believe that Apple might succeed. Apple's done it before. But when Adam's Appliance Repair Garage Holdings (Ticker: AARGH) makes the same claim, you should be more leery.
- The management has a history. If management has a history of starting companies, taking shareholders' money, and leaving them with nothing, then there's a high chance that they'll continue doing what they're good at. Or, if the company seems focused on buying assets from related parties at inflated prices, maybe management isn't in the game just to make money for shareholders.
- Management doesn't believe its own story. If management dumps its shares on the market right when it's putting out the most optimistic, exciting press releases, you should wonder whether the story is being told for your benefit, or the managers'.
A classic example was DHB Industries. In December 2004, at the exact peak of the five-year chart, a handful of insiders dumped their shares. The highlight of the barrage was the CEO, David Brooks, who in one month went from holding 12.8 million shares to 3.1 million. It was an amazingly prescient move, since shares are now trading on the Pink Sheets, down 85% thanks to a combination of faulty products, class action lawsuits, and accounting scandals. To me, the highlight of this disaster is the recent admission that the 2003 and 2004 financial statements -- the statements that investors relied on while insiders were selling -- can no longer be trusted.
- The idea is stupid. If the idea just seems stupid, then there's a good chance that it is. Duh.
Of course, a single warning may be a false alarm, but if the company greets you with several of these warnings, you should think really hard before investing.
The anti-Barnum strategy
The irony is that the richest investor in the world, Warren Buffett, didn't get there by looking for the great new ideas that would transform the world. He got there by being the anti-Barnum -- avoiding the hype and focusing on profitable, established companies with dominating positions. In the late 1980s, Coca-Cola (NYSE: KO ) wasn't hyping the next great gadget. It was just a beverage company trying to increase its already huge global presence. Yet by buying Coke at that time, Buffett made billions. And I think that's the right strategy.
Being an anti-Barnum won't make you rich overnight, but it can make you rich slowly. Because the strategy avoids overhyped high-risk stocks and focuses on the companies most likely to have solid returns, it's the surest path to wealth that I know.
If you're looking for help in navigating that path, we use this approach in our Motley Fool Inside Value newsletter to identify the stocks that we believe are the most likely to outperform. And, unlike Barnum, we're willing to let you see it for free.
Fool contributor Richard Gibbons is a 6-foot-tall chicken, but he wouldn't dream of eating a man. Only small children. He does not have a position in any of the securities discussed in this article. Coke and Dell are Inside Value recommendations. eBay and Amazon.com are Motley Fool Stock Advisor recommendations. The Fool has a disclosure policy.